February High Yield Credit Update

Monthly Commentary

Volatility re-emerged across global asset markets in February with U.S. Treasuries
and equities (and volatility itself) at the epicenter of the quake. The yield on the 10yr
rose +0.14% during the month, +0.24% in a discrete two and a half week period midmonth,
and is now +0.41% higher year-to-date. The Dow was down as much as -12%
from the highs intra-month (evaporating ~$800bn of market value), before bouncing
off the lows and closing down -4.3% for the month (+1.3% for the year). Finally, VIX
spiked over 40pts from historic lows, decimating returns of (levered) short volatilitylinked
ETF and ETN products.

The tremors emanating from those “other” markets were by no means ignored
by high yield investors, though the reaction function ultimately proved relatively
measured and orderly, at least thus far. Indeed, market-clearing prices were guided
lower as benchmark yields rose +0.36%, attributable to both rising interest rates
and widening of credit spreads, but void of any measurable outbreak of panic selling
(although it felt close to the tipping point on more than one occasion). Spreads
widened +17bps on the month to +336bps (option-adjusted), moderating from
intra-month highs of +369bps. After the dust settled, average high yield bond price,
yield and spread stood at $99.59 (-$1.3 year-to-date), 6.14% (+0.42%) and +336bps
(-7bps), respectively. With risk premiums still tighter on the year, the volatility in
February may have unwound the excesses reached in January, though valuations
remain at cyclical peaks.

Market Performance

High yield bonds returned -0.85% in February as rising interest
rates and widening credit spreads (during the first half of
the month) drove bond prices lower with ~50bps of monthly
coupon unable to recoup the delta. Notably, the negative
price action this month was the worst since the depths of the
commodity-led downturn – less a comment on the magnitude
of the negative performance this month as it is on how much
volatility has been dampened for the past two years.

High Yield Bonds Total Return in February
Was the Worst Since January 2016

Source: Barclays

While not immune from interest rate volatility, wider spread,
lower duration Single-B and CCC-rated bonds outperformed
tighter spread, empirically interest rate sensitive BB-rated
credits. BBs returned -1.1% while Single-B and CCC cohorts
returned -0.7% and -0.8%, respectively. While decompression in
credit spreads across the quality spectrum did emerge amid the
macro volatility (stocks, interest rates and HY fund flows), the
initial move was modest and partially remediated by the end
of the month. Indeed, while rising interest rates may eventually
prove destabilizing for credit fundamentals and drive risk
premiums much higher, this was not the case in February.

Source: Barclays

Although the impact of rising interest rates and macro
volatility was fairly systemic in its impact on market prices, a
few idiosyncratic catalysts drove (modest) dispersion at the
sector and credit level. Retailers were the best performing
sector this month led by Rite Aid as the company’s unsecured
debt rallied upwards of +8pts after it was announced the
company has agreed to merge with Albertsons. Restrictive
covenants in the Rite Aid bonds require the debt be taken out
at a premium to effect the merger and, as a result, the market
quickly re-priced the debt higher. Other sectors buttressed
by positive moves in large (predominantly stressed) capital
structures include Consumer Products (Revlon), Media (Clear
Channel Outdoor) and Cable/Satellite (Intelsat). The latter saw
both senior and subordinate bonds rally +8pts and +12pts,
respectively, as investors re-underwrote the probability the
company will be able to monetize its excess C-band spectrum
for use in terrestrial 5G networks someday. Underperforming
on the month was the Energy complex (Oil Field Services and
Independent E&Ps), remediating with crude oil prices following
solid gains in January. Also, Supermarkets were in the red as
regional grocer Tops Markets filed for bankruptcy protection.

Market Technicals

The exodus of investment from the high yield market stands
in stark contrast with positive inflows into virtually all other
risk asset classes. High yield mutual funds and ETFs had
net outflows of over $18bn in 2017 and thus far in 2018, net
outflows have totaled an incremental $14bn. The majority of
the exodus this year was realized in February with over $9bn
in net outflows from active and passive funds (excluding some
likely double counting as active fund managers pulled money
parked in ETFs to satisfy liquidity demands). Notably, the
targeted outflows from HY are a bit puzzling. Fear over rising
interest rates seems to be a reasonable driver, particularly with
the concurrent inflows into floating rate loan funds, though
higher duration / higher interest rate sensitive IG credit did
not see commensurate outflows. Fear of credit loss is also
a historical driver, particularly this late in the cycle, though
spreads near cyclical tights would argue an impending default
cycle is of little concern currently. Quite possibly the reason for
the exodus is simply very poor absolute (and relative) value? Whatever the driver, underlying technicals currently create
fertile ground for disruption.

The High Yield Market Has Seen Targeted
Outflows Over the Past Several Months

Source: Credit Suisse, EPFR

Source: Lipper, JP Morgan

The primary market nearly ground to a halt this past month
as seasonally light volumes were further depressed by market
volatility. Fourth quarter earnings blackout periods typically
slow primary issuance, however, the pipeline for opportunistic
deals was stalled as issuers, citing poor market conditions,
opted to wait for better execution. Only $12bn in USDdenominated
high yield debt was issued this month, a two-year
low (comparable to the low issuance seen during the peak of
the commodity-led downturn in late-2015/early-2016). Those
deals that did brave the storm were skewed towards the Energy
complex (a consistent theme thus far in 2018) and lower credit
quality issuers that are less concerned with paying an extra
0.25-0.5% than they are with not missing this window when the
capital markets remain extremely accommodative.

Fundamental Trends

February saw an uptick in corporate default activity, anchored
by the ~$16bn capital structure of iHeartMedia. One of the
few remaining pre-crisis LBOs, iHeart is in negotiations with
lenders to restructure its over-leveraged balance sheet following
several years of “kick the can down the road” capital markets
transactions and liability management maneuvers. iHeart
represents the largest corporate default since Caesars filed
for bankruptcy in December 2014. In addition to iHeart, four
companies defaulted on their debt obligations this month,
representing ~$2.3bn of bonds and loans. The trailing
12-month high yield default rate of ~2%, remains at cyclical
lows, with the consensus call among market strategists for
an extrapolation of the low default environment into the
foreseeable future.

iHeartMedia Missed an Interest Payment
On February 1st,
Triggering Restructuring Negotiations for
One of the Last Remaining Pre-Crisis LBOs

Source: JP Morgan
Excludes the record setting defaults of Energy Futures’ $36bn default in April 2014 and
Caesar’s $18bn default in December 2014.